Unit Economics for Startups: Why It Matters and How To Calculate It

Published October 28, 2016

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  1. What Is Unit Economics for Startups? A Crash Course
  2. How To Calculate Unit Economics for Your Business
  3. The Importance of Good Unit Economics for Startups
  4. Track Your Key Metrics with Visible

By now, most startup founders are exhausted by the seemingly endless talk of a tech bubble and the inevitable wave of destruction that never seems to arrive. It may not be time to hit the panic button, but the ever-present buzz around bubbles provides a reminder that any business built without a strong foundation will be (and has always been) vulnerable as the favorable tides turn.

What Is Unit Economics for Startups? A Crash Course

Eventually, all the delusions of grandeur you may have developed around your startup must be tested with a real financial model that’s easy to communicate to your investors. Sure, in the early days, you can attract capital by telling ambitious, untested stories of rapid growth and high margins.  But when the rubber meets the road, the success of your business can’t be dependent on a series of hypothetical.  Instead, you need to satisfy investors with an easy-to-explain model that demonstrates a formula for growth. That starts with a grasp on your company’s unit economics.

Unit economics are the foundation that sustains your business as it scales. If you understand your unit economics, you understand what needs to happen and what needs attention in your business in order to hit your goals. This is essential when it becomes necessary to determine how much you can invest in the business to get an expected return. With positive unit economics, you’ll develop your projected return on investment and also make forecasting easier in the future. No matter what stage your business is in, you need the following basics:

  • How much direct revenue is coming in?
  • What are the costs associated with the business?
  • What’s our unit of measurement? (one customer per unit for SaaS companies)

Then you can begin to paint a picture for your investors of your company’s customer acquisition efforts and lifetime value projections that hopefully provide a high margin return on their investment. Triple digit revenue growth is meaningless if you’re not providing a path to earn real margins on the customers you are acquiring.  As Sam Altman notes, many of the poorly constructed startups he sees today rely on wild assumptions untied from traditional unit economics considerations: infinite customer retention projections, an implausible reduction in labor costs or a highly doubtful steep drop in the cost to acquire users. “Most great companies historically have had good unit economics soon after they began monetizing, even if the company as a whole lost money for a long period of time,” Altman said.

The Unit

Depending on your business model, how you classify a “unit” might differ. For a software company, this could be one customer. For a company selling a physical product, this could be one product. 

Customer Lifetime Value (LTV)

A crucial aspect of your unit economics is understanding the value of a single customer. LTV is simply the lifetime value of one customer (or average order value (AOV) for an ecommerce store). This not only helps inform your unit economics but can help teams develop go-to-market strategies and product decisions.

As an example for a startup company, let’s say their customer’s lifetime is on average 22 months and they pay $100 a month. That would be a lifetime value of $2,200.

Customer Acquisition Cost (CAC)

As we wrote in our guide, Customer Acquisition Cost (CAC): A Critical Metrics for Founders, “CAC is the sum total of the amount that it takes your business to acquire a customer, including time from your sales representatives and marketing and advertising expenses.”

Customer acquisition is important when calculating your unit economics because you need to understand what it to takes to acquire a customer. 

Lifetime Value (LTV) vs. Customer Acquisition Cost (CAC) 

In order to better understand your acquisition efforts, you can calculate your LTV:CAC ratio. As we put in our guide on LTV:CAC ratio, “to make your cost to acquire is worth the lifetime value of the customer, it’s helpful to check the ratio between both. LTV:CAC ratio measures the cost of acquiring a customer to the lifetime value. An ideal LTV:CAC ratio is 3 (your customer’s lifetime value should be 3x the cost to acquire them). “

Customer Payback

Customer payback period is exactly what it sounds like – the amount of time it takes to payback the acquisition of a new customer.

For example, let’s say it costs a company $500 on average to acquire a new customer and they pay $100 a month on average. That would be a payback period of 5 months ($500 CAC/$100 MRR). Note: This is the simplest form of calculating a payback period — there are formulas that take into account gross margins.

How To Calculate Unit Economics for Your Business

Now that we understand what unit economics are and why they matter to your business. We need to find a way to calculate and track them specific to your business. 

Method 1: Defining the Unit as One Item Sold

Calculating your unit economics based on a single item is sold is very straightforward. You simply take the revenue per unit and subtract the costs to sell 1 unit. 

Method 2: Defining the Unit as One Customer

When calculating the unit economics for one customer (or one software user). You use the customer acquisition cost and lifetime value metrics we mentioned above. You can use the LTV:CAC ratio to understand this relationship or subtract your CAC from LTV to understand the profitability of a single customer. 

Example Unit Economics Table

Here’s a sample model we developed that helps you demonstrate your company’s financials. Below, you can see the secondary performance indicators to include to develop a wider look at your company’s unit economics:

Scenario A
Average Contract Value (ACV) $5,000 $5,000 $5,000 $5,000 $5,000 $5,000 $5,000
Gross Margin 85% 85% 85% 85% 85% 85% 85%
Gross Profit $4,250 $4,250 $4,250 $4,250 $4,250 $4,250 $4,250
Customer Acquisition Cost (CAC) $14,286 $14,286 $14,286 $14,286 $14,286 $14,286 $14,286
Sum of all Sales & Marketing Expenses $500,000 $500,000 $500,000 $500,000 $500,000 $500,000 $500,000
Number of New Customer Added 35 35 35 35 35 35 35
Churn Rate 8% 8% 8% 8% 8% 8% 8%
Expansion Rate 0% 0% 0% 0% 0% 0% 0%
Lifetime Value (LTV) $53,125 $53,125 $53,125 $53,125 $53,125 $53,125 $53,12

It’s wise to have this level of detail available to investors in your regular updates. With a model like this you can help answer some of the most pressing questions facing your startup: Are you maximizing retention rates to justify the cost to acquire? Are you delivering the expected conversion rate on the money you’re spending to attract new leads? Is the revenue per user outpacing the cost to serve? As your business scales, are you seeing an expected decline in churn rate?

The Importance of Good Unit Economics for Startups 

Unit economics are the lifeblood of a business. Without a scalable and profitable way to acquire customers, a business will cease to exist. In order to improve your unit economics, you need to keep an eye on and track your efforts. Check out a few examples below:

Raising Venture Capital

The strength of your unit economics will be one of the key competitive advantages in a venture capital market that many predict will toughen considerably as the cost of that will toughen considerably for founders over the next 5-10 years.  “The question that will immediately follow, ‘What is your annual growth rate?’ will be ‘What are your unit economics?’” Tomasz Tunguz predicted. “This change in investor mentality is catalyzed by the increasing cost of startup capital.” 

It’s not going to get any cheaper to run your startup or raise serious capital to keep things going. And if you’re earning low-margins, face a high-level of competition and are looking out on a short runway, your financials won’t inspire confidence in your investors. On the other hand, if you have racking up short-term loses on customer acquisition, but can clearly demonstrate your customer payback period and lifetime value, you’ll be an attractive target for investment. Learn more about raising capital in our guide, The Understandable Guide to Startup Funding Stages.

Acquisition Improvements

Tracking your unit economics forces you to keep an eye on your acquisition efforts and go-to-market strategies. If you launch a new acquisition campaign and begin to see your CAC is on the rise — it might be time to evaluate and tweak your new acquisition model. Keeping tabs on your acquisition efforts is a surefire way to grow your business. 

Growing & Scaling

As we mentioned above, tracking your acquisition efforts is a great way to grow your business. By doing so, you’ll be able to understand what channels work best. You’ll be able to invest in the channels that work best so you can grow your company in an efficient manner. 

Track Your Key Metrics with Visible

Markets fluctuate and conditions will better and worsen as your time goes on. But with a strong approach to unit economics, you are making responsible choices and setting yourself up to easily handle investor communication. It might not be the sexiest approach to drawing interest from top venture capitalists, but it’s a solid foundation that helps you build any kind of business.

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